Now that the Bank of Canada has clearly put itself on the path to interest rate cuts the word “divergence” is routinely working its way into economic conversations.
What is “Divergence”?
In this case divergence is the difference between the Bank of Canada’s benchmark, overnight policy rate and the policy rate set by the U.S. Federal Reserve. That difference almost always has an effect on the value of the Canadian dollar relative to the American dollar. Many analysts believe it could limit how much and how fast the BoC can trim rates.
The Current Situation
Right now, the policy rate in Canada is 4.75% following a long awaited quarter-point cut on June 5th. In the U.S. however, the Fed Rate sits at 5.25% to 5.5%, unchanged as of the June 12th setting.
In Canada high interest rates have slowed the economy and pulled inflation back inside the BoC’s 1.0% to 3.0% target range. But in the U.S. the economy remains strong and inflation continues to run hot, at 3.27%.
At its June 12th meeting the Fed noted that it now expects to make just one rate cut this year, down from the previous forecast of three. In Canada analysts are forecasting three more rate cuts by the end of 2024. That could put Canada’s rate as much as 1.25% lower than the States’.
Room to Move
Bank of Canada Governor Tiff Macklem has recognized that there are limits to how much Canada can diverge from the U.S. But he told an audience in Montreal that the Bank is nowhere near that limit. He did not say what, exactly, the limit is.
Divergence Happens
Divergence in the Canadian and American policy rates is not uncommon and, historically, a difference of 100 basis points – or one percentage point – has been seen as the comfort zone.
There has been severe divergence in the past. In the period between 1994 and 1997 Canadian rates dropped to 250 basis points below the American rates, and the value of the Loonie fell to 63 cents U.S.
What It Could Mean
Of course, as the Canadian dollar devalues it makes the purchase of foreign goods more expensive which presents the risk of reigniting inflation.
At the same time Canadians are more sensitive to high interest rates. This is largely due to the five-year mortgage terms used here, compared to the 30-year terms that are the norm in the U.S. This means more Canadians are renewing their mortgages during this period of high rates which, in turn, has seen consumers rein-in their spending.
Canadians are also carrying heavy debt loads. Household debt-to-income now stands at 176%. In other words, the average Canadian household owes $1.76 in debt for every $1.00 of disposable income it has to spend. That number has been coming down recently, but it remains among the highest in the world.